naked capitalism

By Swedish Lex, an expert and advisor on EU regulatory and political affairs:

If you belong to those who believe that the debate on how to fix finance is mightily underwhelming when compared to the latter’s monumental failure, then I suggest reading Martin Wolf’s latest column in the Financial Times.

Wolf essentially trashes the financial system and the remedial actions taken thus far, Michael Moore-style:

What entered the crisis was, we now know, an ill-managed, irresponsible, highly concentrated and undercapitalised financial sector, riddled with conflicts of interest and benefiting from implicit state guarantees. What is emerging is a slightly better capitalised financial sector, but one even more concentrated and benefiting from explicit state guarantees. This is not progress: it has to mean still more and bigger crises in the years ahead.

In Wolf’s view, the separation of utility banking from casino activities would be insufficient as there still would be a risk of the temptations of shadow banking leading to new bubbles and collapses. It seems that Wolf has taken the points made by Carmen Reinhart and Kenneth Rogoff in their recent book “This Time Is Different: Eight Centuries of Financial Folly” to heart. Wolf’s review of the book was published in the FT a couple of days ago. A few notable quotes from Wolf:

Cycles of confidence and panic are inevitable in our world of debt, be that debt public or private, domestic or foreign. Credit is extended freely and then withdrawn brutally.

Financial systems are accidents waiting to happen.

The final lesson is that financial liberalisation and financial crises go together like a horse and carriage. It is no surprise, therefore, that the last 30 years have seen waves of financial crises, of which the latest one is merely the biggest.

Importantly, Wolf concludes that regulation thus far has not been the answer but rather part of the problem. He seems to be recommending that large parts of financial activity may have to be outlawed altogether and that status quo is not an option:

The most important point is that where we are now is intolerable. Today’s concentrations of state-insured private wealth and power must surely go. At present, the official sector believes tighter regulation, particularly higher capital requirements, can contain these risks. But this is likely to fail. If it does, we will need to be radical. Yet narrow banking would still not be enough. We would need to rule out quasi-banking. Otherwise, we would soon return to the world of fragility and bail-outs. Funds that replace banks would have to pass the risks directly on to the outside investors. The authorities will not entertain such radical ideas right now. But the financial system is so inherently fragile that radical reform cannot be pronounced dead. It is only dormant.

So, to conclude, Wolf proposes changes to society that would be truly revolutionary, not as a means to achieve lofty and utopian ideals, but rather as a strategy for economic survival. Interestingly, the IMF yesterday published its new Global Financial Stability Report which contains an analysis of the inadequate policy responses by governments thus far and recommendations for future action. The parallels with Wolf’s thinking are striking, although the IMF obviously uses a different language:

A clear vision of future financial system regulation is needed to provide clarity and boost confidence.

In addition to a well-defined strategy for unwinding unconventional policies, confidence in the financial system will be bolstered by clarity over future regulatory reforms needed to address systemic risks. The recent easing of tail risks should not prompt authorities to relax their efforts to map out the path to a more robust financial system. A holistic, understandable approach needs to be formulated so that the private sector can plan appropriately. The priority should be to reform the regulatory environment so that the probability of a recurrence of a systemic crisis is significantly reduced. This includes not only defining the extent to which capital, provisions, and liquidity buffers are to rise, but also how market discipline is to be reestablished following extensive public sector support of systemic institutions in many countries.

There are already proposals that will go some way toward removing procyclicality in the financial system and increasing buffers against losses and liquidity dislocations. But hard work lies ahead in devising capital penalties, insurance premiums, supervisory and resolution regimes, and competition policies to ensure that no institution is believed to be “too big to fail.

So, if we accept that the existing system is deeply flawed and that the necessary and desirable reforms are seriously lagging, the next question is; who is going to do the lifting? Wolf is entirely mute on this point but one has to assume that since the theme of his column is finance as such, unilateral UK action is not what he has on his mind. If Wolf’s thinking is limited to the UK alone then the City as we know it would be transformed into a museum. In order for Wolf’s vision for a new financial order to be effective, action would have to cover as many jurisdictions as possible. In fact the IMF Report discusses what it views as a need for globally coordinated policymaking and warns against regional solutions:

A macroprudential approach to global policymaking is needed to restore market discipline and ensure that the benefits of financial integration are preserved.
The further challenge is to place these reforms in the context of an integrated macroprudential policy framework in which both domestic and cross-border institutions can operate securely. There is now recognition that a combination of microprudential and macroeconomic policies operated procyclically and led to a buildup of leverage and systemic risk. Policymakers will need to address ways in which their own actions exacerbate systemic risks, regardless of whether they oversee monetary, fiscal, or financial policy. Cooperation and consistency in the policy field must extend across borders. Cross-border relationships between institutions and markets have made it impossible for policymakers to act unilaterally without consequences for others. Following the crisis, however, there is a danger that some countries will want to ring-fence their institutions and withdraw from global markets to protect their domestic economies from external shocks. What is needed instead is a way to benefit from increasing financial integration, while ensuring that potential negative spillovers are contained and clarity exists about the roles of home and host authorities. As policymakers move forward on this difficult task, the IMF can play a catalytic role through its surveillance activities and work on global macrofinancial linkages.

While I would agree with the IMF on the principle, I think it is wholly unrealistic to think that the Fund would be in a position to develop and broker the type of fundamental change that Wolf and, as it seems, the IMF, at least to some degree, are advocating. I furthermore have no expectations at all that the U.S. would be in a position to introduce the kind of reforms Wolf are suggesting, even if it, miraculously, wanted to.

This leaves us with the EU. The EU’s response to the crisis thus far clearly falls short of what Wolf is suggesting although a thorough analysis and reform program of EU policy for the financial sector is under way. The EU however possess the legal competence, the scope and the clout to undertake the kind of reforms that Wolf is suggesting although such a program would be as comprehensive and far-reaching as the introduction of the Euro and would entail a clear break with existing policies. Impetus for a grand projet to re-design the EU’s approach to finance would have to come from the highest political level with the full support of Germany and France. With Merkel re-elected on a platform of financial reform, Sarkozy unthreatened on the domestic political scene and with support from the European Parliament and Commission, such a development could not be ruled out entirely. Since the IMF now estimates that we still have a 1,5 trillion in writedowns ahead of us, at least, politicians might soon have to consider all options, including Wolf’s revolutionary ideas.

It would be interesting to hear what Wolf has to say on how his ideas for radical reform should be implemented and by whom. Perhaps for his next FT column?

It isn’t uncommon for a theme or a trend to dominate how investors and analysts view a particular sector. For instance, when barriers to interstate banking were lowered, then dropped, bank consolidation was all anyone seemed able to think about, even though there were other important developments in the industry. During that era, at McKinsey, a slide show made fun of typical presentations to banking clients. One had a cartoon of an a school of little fish fleeing an enormous fish with a wide open mouth and sharp teeth. Caption: “Citibank is about to enter your market.”

But while some banks were gobbled up by bigger ones, it was often because it served the executives to do so, rather than because it was a business imperative. Well-run small banks can do well; in fact, beyond a not-very-high threshold, banks do not show economies of scale (it may be that the diseconomies of scope outweigh the scale advantages within particular activities).

Similarly, in the dot com era, even stodgy industrial companies would feel compelled to show that they were somehow taking part of this (the seemingly) earth shaking change.

The rising influence of China is another sea change that investors and companies can nevertheless overdo. This tidbit comes from Andrew Kaplan, a hedge fund manager who focuses on the technology and alternative energy sectors:

From American Superconductor’s June quarterly earnings call, 7/30/09:

In 2008, China grew its installed base of wind turbines to about 12 gigawatts of power and early this year declared that it intended to add another 10 gigawatts or more in 2009…more recent reports state that China may exceed 150 gigawatts by 2020. To put all those numbers in perspective, one gigawatt is enough electricity to power…about 3,000,000 Chinese homes. It’s quite clear that the opportunity in China is tremendous and we are definitely taking advantage of the situation.

The 150 gw number by 2020, while it seems large, would be largely achieved if China kept its pace of wind installations flat with its 2009 number (10 gw).

China’s population is 1.3 billion. At current growth rate, population will be 1.4 billion in 2020.

Average household size in China (blended avg of urban + rural) is 4.0.

So in 2020 there will be 350 million Chinese households.

Given that 1 gw of wind can power 3,000,000 Chinese homes, 150 gw of wind will be able to power 450 million Chinese homes.

So in 2020 wind will account for 129% of Chinese household electricity use.

That’s all. You may now return to regularly scheduled programming. (and, yes, I know that households are not the only consumers of electricity. But, believe it or not, wind is not the only source of electricity in China).

New Botnet May Have Infected Half of Fortune 1000 PC Magazine (hat tip reader John Doe)

Alternative Energy Projects Stumble on a Need for Water New York Times. Looking at energy and water in isolation from each other is sure to lead to sub-optimal solutions. Although water rights have long been contested in the Southwest, this piece illustrates a much broader issue.

IMF to raise world economic growth forecast: paper Reuters

Plenty More Bank Losses Expected Globally Wall Street Journal versus IMF cuts global debt writedown estimate to $3.4 trillion Reuters. Just so you know, tier 1 capital of the top thousand banks in the world is a bit north of $4 trillion and most of the losses were replenished by governments, so the credit crisis was a bit of a wipeout, in case you had any doubts on that front.

Home prices stabilized, but… James Hamilton, Econbrowser

The genuine nobility of manufacturing Luke Johnson, Financial Times

Vanilla is a commodity Steve Waldman

CMBStress resumes FT Alphaville

Antidote du jour:

Dear patient readers,

The manuscript has gone in after copy edits and some major revisions (some across the book reordering to tighten the argument and clear up redundancies, and a ton of work on one chapter which has some primary research). There is still pre-galley proofreading (they do it and I review it) and I may be able to do some surgical interventions, but the big push is past.

I had a great deal of help in the final phase of this Bataan death march from quite a few readers, two of whom, Andrew Dittmer and Richard Smith, were very intensively involved in the ten days, and two others (Tom Adams and a reader who prefers to remain anonymous) were critical resources in nailing down some technical details on a complex trading strategy that the book discusses at some length in one chapter.

Others who have been involved in the book on an ongoing basis (Tom Ferguson, Doug Smith, Satyajit Das, Marshall Auerback, Rob Parenteau) provided badly needed sanity checks on a range of topics. A team of readers who had volunteered to do research (Doru Lung, Ben Fisher, Olivier Daviron, Falk Mazelis, Marc Kelechava, Iain Simpson, Jason Windawi, Megan Fries) provided prompt and helpful responses when I could not run something down quickly on Google. Kristina Melomed took up the task of citation checking.

Ed Harrison stepped into the breach on the blog, not only providing quite a bit of his own commentary, but also taking on the additional task of vetting and posting guest post submissions.

This is only a partial list of the people who made important contributions to the book, but I wanted to single out the ones who helped with the final push to get it completed on time.

I am still a bit fried and want to get back to blogging, but I also did not read ANY news for a week, which makes me a bit nervous about the risk of saying something and missing a critical detail. So I will be in catch up mode on a number of fronts which probably means lighter than normal volume for the next few days.

Thanks again for your interest and support!

(Yves should be back  – and so the site should return to normal – tomorrow. If all goes according to plan, you’ll be hearing a lot less from me for a week or so. Yves’ book – Econned - will be quite valuable, and so well worth the wait. )

By George Washington of Washington’s Blog.

I have repeatedly argued that over-the-counter credit default swaps (CDS) – or at least at least “naked” CDS – should be banned (”naked CDS” is the term I coined to describe the situation where the buyer is not the referenced entity. I will not comment on whether or not there is a real economic benefit when the referenced company buys CDS concerning itself or its suppliers as an insurance policy; I will leave that analysis to the CDS experts).

Says Who?

I’m in good company, of course, as many economists and financial advisors have warned of the dangers of CDS:

• A Nobel prize-winning economist (George Akerlof) predicted in 1993 that CDS would cause the next meltdown

• Warren Buffett called them “weapons of mass destruction” in 2003

• Warren Buffett’s sidekick Charles T. Munger, has called the CDS prohibition the best solution, and said “it isn’t as though the economic world didn’t function quite well without it, and it isn’t as though what has happened has been so wonderfully desirable that we should logically want more of it”

• Former Federal Reserve Chairman Alan Greenspan – after being one of their biggest cheerleaders – now says CDS are dangerous

• Former SEC chairman Christopher Cox said “The virtually unregulated over-the-counter market in credit-default swaps has played a significant role in the credit crisis”

• Newsweek called CDS “The Monster that Ate Wall Street”

• President Obama said in a June 17 speech on his plans for finance industry regulatory reform that credit swaps and other derivatives “have threatened the entire financial system”

• George Soros says the market is still unsafe, and that credit- default swaps are “toxic” and “a very dangerous derivative” because it’s easier and potentially more profitable for investors to bet against companies using them than through so-called short sales.

• U.S. Congresswoman Maxine Waters introduced a bill in July that tried to ban credit-default swaps because she said they permitted speculation responsible for bringing the financial system to its knees.

• Nobel prize-winning economist Myron Scholes – who developed much of the pricing structure used in CDS – said that existing over-the-counter CDS were so dangerous that they should be “blown up or burned”, and we should start fresh

• In perhaps the most anti-derivatives statement of all, Nassim Nicholas Taleb said this month, “To curb volatility in financial markets some financial products ’should not trade,’ including complex derivatives.”

But CDS seller are now saying everything is fine, that they are making changes which reduce risk, and that the danger has passed.

As an article in Bloomberg noted this week:

A year after the bankruptcy of Lehman Brothers Holdings Inc., credit-default swaps have lost their stigma for disaster.

So are CDS really safe now?

Not So Safe

Well, initially, before we can even begin to have an intelligent discussion about this issue, it is important to note that – according to Satyajit Das, a leading credit default swap expert – the commonly-accepted figures for the CDS losses suffered due to Lehman’s bankruptcy have been understated.

And it is also important to acknowledge that the government’s proposed regulations of CDS (if they ever pass) won’t really fix the problem. Indeed, Das says that the new credit default swap regulations not only won’t help stabilize the economy, they might actually help to destabilize it.

And it should be remembered that the overwhelming majority of derivatives are held by just 5 banks. So the people behind the effort to reassure everyone that CDS are safe again are the too big to fail banks, desperate to restart the toxic asset and exotic instrument gravy train.

And the big financial firms and the government are both desperate to increase leverage, rather than allowing the deleveraging play out. See this, this, this, this and this.

As Nouriel Roubini said last month:

This is a crisis of solvency, not just liquidity, but true deleveraging has not begun yet because the losses of financial institutions have been socialised and put on government balance sheets. This limits the ability of banks to lend, households to spend and companies to invest…

The releveraging of the public sector through its build-up of large fiscal deficits risks crowding out a recovery in private sector spending.

CDS are an important way of creating leverage (for example, last year, the market for credit default swaps was larger than the entire world economy). So there is a huge (although wrong-headed, in my opinion) incentive to underplay the risks of CDS.

It is also possible to argue (although I haven’t seen this argument validated by any experts) that CDS are inherently destabilizing for the financial system since they increase interconnectivity.

And don’t forget that credit default swap counterparties drive company after company into bankruptcy, and that – once a company the counterparties aare betting against goes bankrupt – the counterparties cut in line in front of all of the bankruptcy creditors to get paid (and see this). In other words, there are other problems caused by CDS other than destabilizing the economy as a whole.

Interesting Alternatives

Two of the most interesting proposals in dealing with CDS come from Paul Volcker and Yves Smith.

Volcker argues that banks which receive taxpayer bailouts should not be heavily exposed to derivatives trading.

Yves Smith says that the best approach would be to significantly tax credit default swaps.  She argues that that would shrink the CDS market – and the associated risks – faster than anything else. The more I think about it, the more Smith’s approach makes sense.

The Bigger Problem

Perhaps most importantly, CDS sellers – like the big sellers of other financial products – know that the government will bail them out if CDS crash again. So they have strong incentives to sell them and to recreate huge levels of leverage.

Indeed, the same dynamic that led to the S&L crisis also led to last year’s CDS crisis, and will lead to the next crisis as well. So – while CDS might be a particularly dangerous type of “weapon of mass destruction” (in Buffet’s words) – the financial looters will probably find some way to loot on the public’s dime, no matter what happens to CDS, unless they are they are meaningfully reigned in (or broken up).

In other words, the bottom line is that – yes – CDS are still dangerous. But – just as a killer, unless restrained, could use a paper weight to kill – the too-big-to-fails would just use some other instrument even if naked over-the-counter CDS are banned or tamed. Taking away a convicted murderer’s gun might be a good first step. But if he is still free to cause harm, he may very well kill again.

By George Washington of Washington’s Blog.

(Rest assured that once Yves is done writing her book, and back posting,  or other guest posters write more, I will post less often! )

This essay rounds up arguments for gold as a reasonable investment.

China

Commentators such as Ambrose Evans-Pritchard and Byron King argue that China’s hunger for gold will put a floor on gold prices.

Specifically, they argue that China will “buy the dips” in gold prices, effectively putting a minimum on how low gold prices can go.

Inflation

It is conventional wisdom that gold is a hedge against inflation.

For example, noted inflationist John Williams advises buying gold.

Axel Merk argues that gold is a better buy than TIPS as an inflation bet.

And Taleb advised buying gold in May, since currencies including the dollar and euro face pressures.

Deflation

If gold does well during times of inflation, it makes sense that it would perform poorly during deflationary periods.

But Examiner.com points out that such an assumption is probably untrue.

Specifically, as Examiner.com writes:

Eric Sprott – who manages $4.5 billion in assets, and correctly predicted in March of 2008 a “systemic financial meltdown” – says:

“I believe no matter what environment you’re in – deflation or inflation – people will run to gold,” Sprott said. “Gold is proving exactly what we all would have expected, that in almost any environment, it’s a go-to asset.”

And investment analyst and financial writer Yves Smith argues that gold does well during both periods of deflation and high inflation. She argues:

Historically, gold does well [in] hyperinflation and deflationary [periods]. Gold does poorly under more normal conditions, and gets hammered in disinflationary conditions, a falling but positive rate of inflation.

Analyst Adrian Ash argues that gold’s value actually increases during periods of deflation even if its price drops:

Does the price of gold rise or fall in a deflation?Hint: It’s a trick question, already tripping up plenty of would-be advisors…

Absent the money-supply limits which the gold standard imposed on the world, people rightly guess that double-digit inflation would prove rocket-fuel for the bull market in gold. Yet the purchasing power of gold nearly doubled during the Great Depression, and it’s risen four-fold during this decade’s low consumer-price inflation as well.Why? Because both those periods of low price-inflation saw the money-issuing authorities devalue the currency, first with explicit reference to gold but now without daring to name it. Roosevelt in the mid-30s slashed the dollar’s gold content by 40%; the Greenspan/Bernanke Fed devalued the Dollar again to sidestep a DotCom Depression, keeping real interest rates at less than zero, between 2002-2005.

The maestro’s apprentice applied the same trick in the back-half of 2008, but so far to no avail. And now even the European Central Bank is pumping out money – a near half-trillion euros today alone – in a bid to revive bank lending, swamp the currency markets, and pull Germany out of its first flirt with deflation since the 1930s.

Just such a devaluation – and again, absent any stated reference to gold – was attempted by the Bank of Japan a little less than a decade ago.

Indeed, Japan is the only developed nation since the end of the gold standard to have suffered an extended deflation in prices. So far, at least. Germany and Switzerland look set to try for a re-wind, and unless the dollar can outpace the euro’s descent, we might yet see truly sub-zero inflation in the United States, too.

But whatever that should mean for gold prices, all other things being equal, just doesn’t matter. Because the gold price will not get a chance. All other things are not equal, and the policy solution – rank devaluation – can only make gold more appealing to investors and savers, whether the “monetarist experiment” of TARP, quantitative easing or a half-trillion euros proves successful or not.

Japan’s slump into deflation coincided with the Bank of Japan’s “zero interest rate policy” (ZIRP) at the start of this decade. It also saw the gold price worldwide hit rock-bottom and turn higher, a move that analysts (including us) have typically linked to US monetary moves and investment cash looking for safety as the Dotcom Bubble exploded.

But zero-rate money from the world’s second-largest economy shouldn’t be ignored. And today, zero-rate money is all the developed world has to offer – a trick that might not beat deflation, but might just spur a whole new rush into gold.

In other words, Ash argues that you can’t take inflation or deflation in a vacuum. During deflationary periods – like we have now – governments always increase the money supply with a flood of new dollars, which is bullish for gold.

And PhD economist Marc Faber wrote in October 2007 that gold will do well even in a deflation:

How would gold perform in a deflationary global recession? Initially gold could come under some pressure as well but once the realization sinks in how messy deflation would be for over-indebted countries and households, its price would likely soar.

Therefore, under both scenarios – stagflation or deflationary recession – gold, gold equities and other precious metals should continue to perform better than financial assets.

Looking At the Charts

Is Faber right?

Well, take a look at the following charts showing gold’s performance as compared to the yen during Japan’s “lost decade” of deflation:

Japan’s deflation didn’t definitively end until 2007 or 2008.

This provides some evidence that gold may tend to hold or increase its value at least in the later part of the deflationary period as compared with the relevant national currency.

Moreover – approximately half the time – gold has risen during recessions in the United States:

(The grey vertical bars show periods of recession; the chart gives gold prices in monthly averages; click here for larger image).

If you study the above chart, you will see that gold seems to often fall during the beginning stages of a recession, then rise in the later stages of the recession (before 1971, the dollar was still backed by gold at a fixed price, and so gold did not fluctuate).

But what about Ash’s theory?

The American Enterprises Institute notes:

After five years in a deflationary economic wilderness, the Bank of Japan switched during the spring of 2001 to a policy of quantitative easing–targeting the growth of the money supply instead of nominal interest rates–in order to engineer a rebound in demand growth.

Look again at the first gold chart for Japan, above. Gold appears to start increasing against the Yen in 2001.

This may provide some evidence for Ash’s thesis that it is an expansion of the money supply which pushes the price of gold up in the later stages of deflationary periods.

Uncertainty

Finally, Chris Martenson argues that – in prolonged periods of deflation – we usually see failures of large and significant banks, institutions, and perhaps even states and countries. Because gold traditionally does well during periods of uncertainty, Martenson likes gold during periods of deflation.

Examiner.com notes in a subsequent article:

Merrill Lynch agrees.

Specifically, PhD economist Nouriel Roubini paraphrases a report from Merill Lynch (not available online) as follows:

Short-term rates of 0% are bullish for gold, which serves as a store of value but is a useful hedge against deflation as well, since deflation is inherently destabilizing for financial assets. In the 2001-03 deflationary period, gold rose more than 30%, not to mention the prospect of a return to a dollar bear market. “Gold is inversely correlated to global short-term interest rates and there is a race right now towards 0%. Production is down 4.0% y/y while fiat currencies globally are being created at a double digit rate by the world’s central banks….As for all the talk of a ‘gold bubble,’ it would take a nearly 625% surge in gold to over US$6,000/oz and a flat stock market to actually get the ratio of the two asset classes back to where it was three decades ago when bullion was in an unsustainable bubble phase.”

Gold tends to be less sensitive to global economic slowdown than industrial metals or energy and works better as a hedge against crisis than inflation.

Global Short Term Interest Rates Are Low

The above-quoted Merrill article states:

Gold is inversely correlated to global short-term interest rates and there is a race right now towards 0%.

This argues for gold.

Polls Show Distrust in Government

Time Magazine writes:

Traditionally, gold has been a store of value when citizens do not trust their government politically or economically.

Given the enormous levels of distrust in the government politically and/or economically (and the fact that some have warned of recession-induced violence), gold might do well.

Greenspan and Exeter

Professor Emeritus of Mathematics Antal Fekete has argued for years that gold is the ultimate – and only – safe haven when things really hit the fan.

For example, in 2007 Fekete wrote:

The grand old man of the New York Federal Reserve bank’s gold department, the last Mohican, John Exter explained the devolution of money (not his term) using the model of an inverted pyramid, delicately balanced on its apex at the bottom consisting of pure gold. The pyramid has many other layers of asset classes graded according to safety, from the safest and least prolific at bottom to the least safe and most prolific asset layer, electronic dollar credits on top. (When Exter developed his model, electronic dollars had not yet existed; he talked about FR deposits.) In between you find, in decreasing order of safety, as you pass from the lower to the higher layer: silver, FR notes, T-bills, T-bonds, agency paper, other loans and liabilities denominated in dollars. In times of financial crisis people scramble downwards in the pyramid trying to get to the next and nearest safer and less prolific layer underneath. But down there the pyramid gets narrower. There is not enough of the safer and less prolific kind of assets to accommodate all who want to “devolve”. Devolution is also called “flight to
safety”.

Darryl Schoon makes the same argument.

Here’s a visual depiction Exeter’s inverted pyramid, courtesy of FOFOA:

(Click here for full image; I am not certain every level of the pyramid is accurately ranked)

Alan Greenspan has just lent some support to the theory. Specifically:

Gold prices that jumped above $1,000 an ounce this week are signaling that investors are buying metals to hedge against declines in currencies, former Federal Reserve Chairman Alan Greenspan said.

The gains are “strictly a monetary phenomenon,” Greenspan said today at an investment conference in New York. Rising prices of precious metals and other commodities are “an indication of a very early stage of an endeavor to move away from paper currencies,” he said…

“What is fascinating is the extent to which gold still holds reign over the financial system as the ultimate source of payment,” Greenspan said.

In other words, Greenspan is saying that investors are moving out of the second-to-lowest step on the pyramid (currencies and government bonds) and into the lowest step (gold).

Greenspan is also verifying what goldbugs like Exeter, Fekete and Schoon have been claiming: that “the barbarous relic” still holds an important place in the modern investor’s psyche.

Are Exeter, Fekete and Schoon right? I don’t know. And Greenspan might be wrong, or trying to excuse weakness in the dollar (as opposed to all paper currencies).

Note 1: Zero Hedge alleges that newly-declassified federal documents prove that gold prices have been manipulated for decades. If these documents are authentic (I have no reason to doubt their authenticity, but have no inside knowledge), if the claims of artificial price suppression are true, if this is widely publicized, if such publicity causes someone like Congressmen Alan Grayson, Brad Sherman, Ron Paul, or Dennis Kucinich to raise a ruckus in Congress, and if Congress as a whole votes to ban such a practice, then the price of gold would presumably rise. That’s a lot of ifs.

Note 2: Some of the best recent arguments I’ve heard against gold are written by Vitaliy Katsenelson. Read this, this, this and this.

Note 3: I am not an investment advisor and this should not be taken as investment advice.

By George Washington of Washington’s Blog.

As I have recently pointed out, there are strong arguments for ongoing deflation.

But even deflationists think that – after a period of deflation – we might eventually get inflation. For example, in October, I guessed 1 1/2 to 2 years of deflation, followed by inflation.

Moreover, noted deflationist Martin Weiss – after predicting for 27 years straight that we’ll have deflation – has now changed his mind, and thinks inflation is a greater short-term threat than deflation.

For these two reasons – and to make clear that the inflation versus deflation debate is complicated and includes many factors – this essay will focus on the arguments for inflation.

Faber and the Dollar

PhD economist Marc Faber said in May:

“I am 100% sure that the U.S. will go into hyperinflation.”

Faber said he thinks – in the medium-term – we could have high levels of inflation (and see this and this).

Faber’s argument is that a weakening dollar will lead to inflation (as every dollar will buy less goods and services).

Government Printing

The government has injected trillions of dollars into the economy in the form of TARP bailout funds and other programs. Indeed, the government’s own watchdog over the TARP program – the special inspector general – said that number could be $23 trillion dollars in a worst-case scenario.

The basic argument for inflation is – as everyone knows – that the government has injected so much money into the economy (through bailouts, quantitative easing, purchase of treasuries, etc.) that there will be a lot more dollars chasing the same number of goods and services, which will drive up prices. In other words, the supply is the same, but demand has increased.

Indeed, the U.S. has also provided huge sums of dollars to foreign central banks. Could dollars given abroad cause inflation inside the U.S.? Yes – because some proportion of those dollars will be spent by citizens in those countries to buy stocks, commodities, goods and services within the U.S.

Three well-known advocates of the inflation argument are Rogers, Buffet and Schiff.

Specifically, billionaire investor Jim Rogers said we are facing an “inflationary holocaust”.

Warren Buffett said:

The policies that government will follow in its efforts to alleviate the current crisis will probably prove inflationary and therefore accelerate declines in the real value of cash accounts.

And Peter Schiff has argued for years that hyperinflation will wipe out the value of the dollar, so people should get all of their money out of dollars and into foreign currencies and assets.

But is all this government printing and quantitative easing really enough to cause inflation?

The back-of-the-envelope figures I’ve seen bandied about say no. Because of the massive destruction of credit (which – as Mish has repeatedly pointed out – must be included in discussions of inflation versus deflation), the government would probably have to print one-and-a-half to two times as much as it already has in order to create inflation.

The government could still do so. Yes, it would be suicidal for the dollar and might cause foreign buyers of U.S. treasuries to stop buying, but the boys in Washington could – if they were crazy enough – increase the money printing and quantitative easing to the point where inflation actually kicks in.

Will they do so? Summers, Geithner and Bernanke have proven themselves willing to do a lot of crazy things over the past year, so I wouldn’t rule the possibility out altogether.

Indeed, when the Option Arm, Alt-A and commercial real estate mortgages start defaulting in earnest, there will be a lot of pressure on Washington to “do something”. But again, doubling the amount of money printing would turn the dollar into monopoly money, and so there will be a lot of pressure not to turn America into Zimbabwe.

Devaluing the Dollar

Many commentators also argue that the U.S. is intentionally devaluing the dollar in order to increase trade.

And – as everyone knows – the dollar might tank even if the boys don’t intentionally devalue it into oblivion. Just look at the amount of printing and easing which has already been done, the tidal wave of debt overhang, and the lack of fundamental soundness in the giant banks, the financial system, and the U.S. economy as a whole.

Moreover, some people argue that the dollar carry trade will drive inflation. Specifically, they argue that we’ll get “spec-flation”, meaning that investors will buy dollars and – in a carry trade – use the dollars to invest abroad. This will devalue the dollar, creating inflation.

And, importantly, the U.S. is quickly losing its status as the world’s reserve currency. Therefore, the “premium” on the value of the dollar for its status as reserve currency will also fade, and the value of the dollar decline.

For these and other reasons, Faber and other inflationists would argue that the dollar will continue to substantially decline and inflation will therefore kick in (Note: Mish is still a dollar bull, and so doesn’t concede this point).

Unemployment

I have previously argued that the rising tide of unemployment will contribute to deflation for some time.

However, Edmond Phelps – who won the Nobel Prize for Economics in 2006 – and PIMCO Chief Executive Officer Mohamed El-Erian both say that the “natural unemployment rate” has risen from 5 to perhaps 7 percent.

What is the natural unemployment rate? It just means that if unemployment falls below that a certain percentage, then inflation will be created.

So if the natural unemployment rate has risen, that may mean that we will get inflation sooner (when unemployment falls to 7%, instead of when it falls all the way back to the previous peg of 5%).

End of Foreign Bond Purchases?

Tiger Management founder and chairman Julian Robertson warns that – if foreign purchasers stop buying U.S. treasury bonds – inflation will strike:

If the Chinese and Japanese stop buying our bonds, we could easily see [inflation] go to 15 to 20 percent,” he said. “It’s not a question of the economy. It’s a question of who will lend us the money if they don’t. Imagine us getting ourselves in a situation where we’re totally dependent on those two countries. It’s crazy.

Bottleneck Inflation

Finally, Andy Xie argues that “bottlenecks” can cause inflation. Specifically, Xie argues that inflation in a single key market – say oil – can cause inflation, even in a weak economy.

Conclusion

As I have argued for a year, we will probably have a period of deflation followed by inflation. I still believe that.

When inflation will kick in is the million dollar question. The inflation camp argues that inflation will kick in any second now without any warning. In the deflation camp, David Rosenberg argues for years of deflation, and Dr. Lacy Hunt argues for decades of deflation.

Bottom line: In my opinion, the question is when, not if.

But in investing, being too early is being wrong. Someone who is positioned for inflation decades too early will get creamed. Likewise, someone who is betting on deflation for 20 years will get hurt if inflation kicks in next month.

Note: Remember that we could also get mixed-flation. In other words, inflation in some asset classes and deflation in others. Indeed, given that speculators drove up the price of oil last year, it is possible that – especially in a stagnant economy – speculators could drive up the prices of some asset classes and drive others down.

Links return September 30!

By George Washington of Washington’s Blog.

How well has the Federal Reserve performed for America? Mainstream pundits, of course, say that Bernanke has saved the world . . . . but they said the same thing about Greenspan.  So let’s look at the actual historical record to determine how well the Fed has done.

Initially, Milton Friedman and Ben Bernanke have both said that the Federal Reserve caused (or at least failed to cure) the Great Depression through its poor monetary policy.

Many also blame the Fed for blowing an unsustainable bubble between 2001-2007 through artificially low interest rates. If this sounds too much like an Austrian economics perspective, that may be true. But remember that Hayek won the Nobel prize in 1974 partly for arguing that artificially low interest rates lead to the misallocation of capital and to bubbles, which in turn lead to busts.

Moreover, one of the Fed’s main justification has been that it can provide a “counter-cyclical” balance. In other words, during boom times it can put on the brakes (”take the punch bowl away right as the party gets started”), and during busts it can get things moving again. But as economist Jane D’Arista has shown, the Fed has failed miserably at that task:

Jane D’Arista, a reform-minded economist and retired professor with a deep conceptual understanding of money and credit [has a] devastating critique of the central bank. The Federal Reserve, she explains, has failed in its most essential function: to serve as the balance wheel that keeps economic cycles from going too far. It is supposed to be a moderating force in American capitalism on the upside and on the downside, the role popularly described as “leaning against the wind.” By applying its leverage on the available supply of credit, the Fed can slow down a boom that is dangerously overwrought or, likewise, stimulate the economy if it is sinking into recession. The Fed’s job, a former chairman once joked, is “to take away the punch bowl just when the party gets going.” Economists know this function as “counter-cyclical policy.”

The Fed not only lost control, D’Arista asserts, but its policy actions have unintentionally become “pro-cyclical”–encouraging financial excesses instead of countering the extremes. “The pattern that has developed over the last two decades,” she wrote in 2008, “suggests that relying on changes in interest rates as the primary tool of monetary policy can set off pro-cyclical foreign capital flows that tend to reverse the intended result of the action taken. As a result, monetary policy can no longer reliably perform its counter-cyclical function–its raison d’être–and its attempts to do so may exacerbate instability.”…

The Fed is also supposed to act as a regulator for banks and their affiliates, but failed miserably in that role as well.

Indeed, the central bankers’ central banker – BIS – has itself slammed the Fed:

In a pointed attack on the US Federal Reserve, [BIS and its chief economist William White] said central banks would not find it easy to “clean up” once property bubbles have burst…

Nor does it exonerate the watchdogs. “How could such a huge shadow banking system emerge without provoking clear statements of official concern?”

“The fundamental cause of today’s emerging problems was excessive and imprudent credit growth over a long period. Policy interest rates in the advanced industrial countries have been unusually low,” [White] said.

The Fed and fellow central banks instinctively cut rates lower with each cycle to avoid facing the pain. The effect has been to put off the day of reckoning…

“Should governments feel it necessary to take direct actions to alleviate debt burdens, it is crucial that they understand one thing beforehand. If asset prices are unrealistically high, they must fall. If savings rates are unrealistically low, they must rise. If debts cannot be serviced, they must be written off.

“To deny this through the use of gimmicks and palliatives will only make things worse in the end,” he said.

As PhD economist Steve Keen has pointed out, the Fed (along with Treasury) has also given money to the wrong people to kick-start the economy.

Remember also that Greenspan acted as one of the main supporters of derivatives (including credit default swaps) between the late 1990’s and the present (and see this).

Greenspan was also one of the main cheerleaders for subprime loans (and see this).

The above list is only partial. And it ignores:

(1) allegations that the Fed has manipulated the markets; and

(2) claims that the Federal Reserve System saddles the U.S. government and American people with trillions of dollars in unnecessary debt (that would not be incurred if the government took back the “power to coin money” granted to the government itself in the Constitution).

Even so, it shows that the Federal Reserve has performed very poorly indeed.

Links return September 30.